Describes the preliminary findings of IMF staff at the conclusion of certain missions (official staff visits, in most cases to member countries). Missions are undertaken as part of regular (usually annual) consultations under Article IV of the IMF's Articles of Agreement, in the context of a request to use IMF resources (borrow from the IMF), as part of discussions of staff monitored programs, and as part of other staff reviews of economic developments.

21 June 2012

Completing the Union to Overcome the Crisis

The euro area crisis has reached a critical stage. Despite extraordinary policy actions, bank and sovereign markets in many parts of the euro area remain under acute stress, raising questions about the viability of the monetary union itself. A determined and forceful move toward a more complete EMU, particularly a banking union and more fiscal integration, is needed to arrest the decline in confidence engulfing the region. These steps should be supported by wide-ranging structural reforms throughout the euro area to raise growth, while demand support should be maintained in the short term to cushion the impact of the region’s adjustment efforts.

1. The financial and economic environment continues to deteriorate. Investors are withholding funding from member states most in need, moving capital to safe havens and driving risk premiums to new records. Demand is weakening and unemployment increasing across the euro area. Lower growth and heightened market stress are compounding the difficulties in reducing debt burdens. The risk of stagnation and long-term damage to potential growth will increase as unemployed workers lose skills and new workers find it difficult to join the active labor force.

2. Important actions have been taken. The ECB has lowered policy rates and conducted special liquidity interventions to address immediate bank funding pressures and avert an even more rapid escalation of the crisis. And the larger European and global firewall will provide more liquidity insurance to sovereigns, while the ongoing reform of fiscal governance, especially the adoption of the Fiscal Compact, will help strengthen budgetary discipline. National governments have also embarked on fiscal consolidation and reaffirmed their commitment to debt sustainability and deficit targets.

3. But the crisis now calls for a stronger and more collective effort. Downward spirals between sovereigns, banks, and the real economy are stronger than ever. As concerns about banks’ solvency have increased—because of large sovereign exposures and weak growth prospects in many parts of the euro area—the effectiveness of liquidity operations has diminished. Sovereigns, in turn, are struggling to backstop weak banks on their own. Absent collective mechanisms to break these adverse feedback loops, the crisis has spilled across euro area countries. Contagion from further intensification of the crisis—including acute stress in funding markets and tensions involving systemically-important banks—would be sizeable globally. And spillovers to neighboring EU economies would be particularly large. A more determined and forceful collective response is needed.

Completing EMU: Banking and Fiscal Union to Support Integration

4. A strong commitment toward a robust and complete monetary union would help restore faith in the viability of EMU. This should encompass a credible path to a banking union and greater fiscal integration, with better governance and more risk sharing. However, achieving this goal will take time and hence requires a clear timeline, with concrete intermediate actions to set the guide posts and anchor public expectations.

5. The immediate priority is concrete action toward a banking union for the euro area. The proposed EU framework for harmonized national bank resolution processes is a necessary first step. But it needs to go further. A deposit guarantee scheme needs to be established at the regional level to help break the links between domestic banks and their sovereigns, and support depositor confidence. A common bank resolution authority is also needed. It should be backed by a common resolution fund to ensure burden sharing and to limit fiscal costs. These efforts should be supported by a common supervisory and macro-prudential framework to forestall further financial fragmentation. While a banking union is desirable at the EU27 level, it is critical for the euro 17.

6. More fiscal integration, with risk sharing supported by stronger governance, can reduce the tendency for economic shocks in one country to imperil the euro area as a whole. Ultimately, this could mean sufficiently large resources at the center, matched by proper democratic controls and oversight, to help insure budget shortfalls at the national level. Getting to this endpoint will take time. But the process can start with a commitment to a broad-based dialogue about what a fuller fiscal union would imply for the sovereignty of member states and the accountability of the center. This should deliver a schedule for discussion, decision, and implementation.

7. Introduction of a limited form of common debt, with appropriate governance safeguards, can provide an intermediate step towards fiscal integration and risk sharing. Such debt securities could, at first, be restricted to shorter maturities and small size and be conditional on more centralized control (e.g., limited to countries that deliver on policy commitments; veto powers over national deficits; pledging of national tax revenues). Common bonds/bills financing could, for example, be used to provide the backstops for the common frameworks within the banking union.

Reviving Growth: Long-term Adjustment

8. To restore growth across the union, long-standing structural rigidities need to be tackled to raise long-term growth prospects. In many countries, labor market reforms are needed to raise participation and address disparities in protection that confine “outsiders” (typically younger workers) to low-wage, temporary jobs. Southern Europe needs to increase competitiveness in the tradables sector. In addition, targeted investment in infrastructure and human capital will support growth and employment. In northern Europe, product market reforms would help generate a more vibrant services sector and help raise overall productivity.

9. Policy efforts should also focus on improving competitiveness, in particular within the euro area. The euro is assessed to be broadly in line with fundamentals, but substantial competitiveness gaps between countries remain to be addressed.

Services sector reforms in the surplus economies could improve disposable incomes and lead to higher external demand, including for deficit economies.

Lowering unit labor costs in the tradables sector is essential for deficit countries. This means productivity-enhancing reforms (e.g., lowering barriers to entry, making it easier for small firms to expand into foreign markets) and labor market measures that ensure that nominal wage developments are aligned with productivity growth.

To foster relative price adjustment between the North and the South, monetary policy should ensure that overall inflation does not drop far below the two percent for the euro area as a whole, while allowing for larger inflation differentials between North and South.

Supporting Growth: Short-term Actions

10. Because structural reforms will take time to generate growth, aggregate demand support is needed in the short run.

Monetary policy cannot provide a lasting solution to the underlying crisis. But with inflationary pressures expected to weaken substantially, the ECB has room, albeit limited, to ease policy rates and signal a commitment to a more accommodative stance for a prolonged period. The ECB also needs to ensure that its monetary support is effective across the region and continue to provide ample liquidity support to banks under sufficiently flexible conditions. If necessary, unconventional measures should be used. This means giving consideration to non-standard measures, such as a re-activation of the SMP, additional LTROs with suitable collateral requirements, or the introduction of some form of quantitative easing.

Fiscal consolidation should proceed decisively and credibly where market pressure is high, but more gradually elsewhere to help support demand in the region. To this end, it is important to focus on fiscal targets expressed in structural, not nominal, terms, and anchor them by fully-specified multi-year plans. In this context, the flexible implementation of the current fiscal framework is essential.

Recapitalization of weak banks—including through direct support from EFSF/ESM resources—will help break the adverse feedback loops between sovereign and banking stress at the national level. At the same time, the EBA, the ESRB, and national authorities should coordinate policies to avoid excessive bank deleveraging and its adverse growth impact.

An IMF team consulted with the European Central Bank, the European Commission, the European Union Presidency, the European Systemic Risk Board, and the European Banking Authority from May 29 to June 11, 2012, for the annual evaluation of the euro area under Article IV of the IMF’s Articles of Agreement. This statement describes the preliminary findings of the staff.